Would you trust a money manager who couldn’t recall the names of the stocks in his portfolio?

Probably not. You expect the person overseeing your investments to have intimate knowledge of every holding. It’s your money on the line, after all. To not know would be reckless and irresponsible.

Yet for Thomas Howard, finance professor, money manager and author of Behavioral Portfolio Management, not keeping track of his portfolio positions or the prices he paid for them is far from irresponsible. In fact, it’s an important part of maintaining emotional detachment and control. When you see news about one of your stocks in the media, it can cause you to have doubts and second-guess your analysis. And the best way to avoid these doubts is to forget the stock’s name.

Likewise, fixating on your purchase price can lead you to make poor decisions due to “myopic loss aversion,” or a common human compulsion to avoid losses—even small ones—at all cost. This tends to cause investors to follow the money-losing path of selling their winners too soon and holding on to their losers in hope of breaking even. The best way to defuse these impulses is to simply forget the price you paid.

Extreme? Absolutely. I would go so far as to call it wildly eccentric. But it’s hard to argue with results. His Pure Valuation portfolio returned 66% last year and has generated annualized returns of 29.2% over the five years to April 30.

Howard’s Behavioral Portfolio Management starts with a summary of basic behavioral finance principles. Much of this is rooted in the work of psychologists Daniel Kahneman and Amos Tversky on heuristics and cognitive biases in the 1970s. Over the past 30 years a massive body of work has been amassed that has challenged—and largely disproved—virtually all of the core assumptions of Modern Portfolio Theory and the Efficient Market Hypothesis. Howard essentially sums up the findings with the observation that “markets do not correctly price assets and…emotion trumps arbitrage.”

Rather than mitigate our emotional impulses, the industry actually enables and exacerbate them. For example, overdiversification—which gives the appearance of reducing risk—actually just has the effect of lowering returns. There is little diversification benefit achieved by holding more than about 20 stocks; 91% of diversification benefit can be achieved with just 20 holdings. Padding a portfolio with 100 or more stocks—which is standard for most mutual funds—has the effect of watering down the manager’s best ideas.

Similar comments have been made in countless other books on behavioral finance. But Howard gives us quite a bit of new—and controversial—observations and offers tips on how to incorporate them into our investing process.

To start, contrary to popular belief, most mutual fund managers are actually very good stock pickers.

Yes, you read that right.

I know, I’ve seen the statistics too. Most mutual funds underperform the S&P 500 over time. One recent study showed that 76% of active mutual funds underperformed their benchmark.

So, it is safe to say that most mutual fund managers as a group are terrible portfolio managers. It does notmean, however, that they are poor stock pickers. Their highest-conviction holdings tend to do very well—a 2010 study referenced in the book showed that a fund’s top holding added, on average, about 6 points of alpha. But in trying to diversify and to avoid “tracking error” relative to their benchmark, managers dilute their portfolios with low-conviction picks that water down their returns and actually subtract alpha.

And speaking of tracking error, Howard takes a very unconventional view: tracking error is good. A manager should stick to a strategy in which they have expertise, whether it be deep value, dividend growth, special situations, or some other niche. But they absolutely should not stick within the narrow confines of a Morningstar style box. A manager should go where their strategy takes them, regardless of market cap or any standard classification.

How does all of this translate into actual investment decisions? Howard recommends the following:

Choose a strategy in which you excel and be consistent within that strategy.

Limit your portfolio to a small number of high-conviction picks. Howard himself keeps his portfolio to ten stocks.

Don’t be afraid to be concentrated in a single country or industry if that is where your strategy takes you.

About the author:

Mr. Sizemore has been a repeat guest on Fox Business News, has been quoted in Barron’s Magazine and the Wall Street Journal, and has been published in many respected financial websites, including MarketWatch, TheStreet.com, InvestorPlace, MSN Money, Seeking Alpha, Stocks, Futures, and Options Magazine and The Daily Reckoning.

Disclaimers: GuruFocus.com is not operated by a broker, a dealer, or a registered investment adviser. Under no circumstances does any information posted on GuruFocus.com represent a recommendation to buy or sell a security. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The gurus may buy and sell securities before and after any particular article and report and information herein is published, with respect to the securities discussed in any article and report posted herein. In no event shall GuruFocus.com be liable to any member, guest or third party for any damages of any kind arising out of the use of any content or other material published or available on GuruFocus.com, or relating to the use of, or inability to use, GuruFocus.com or any content, including, without limitation, any investment losses, lost profits, lost opportunity, special, incidental, indirect, consequential or punitive damages. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, investment advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. The gurus listed in this website are not affiliated with GuruFocus.com, LLC.
Stock quotes provided by InterActive Data. Fundamental company data provided by Morningstar, updated daily.